I have a question from qbank, 7-11 Financial reporting and analysis. Camphor Associates uses accrual basis for financial reporting purposes and cash basis for tax purposes. Cash collections from customers is $238,000, and accrued revenue is only $188,000. Assume expenses at 50% in both cases (i.e., $119,000 on cash basis and $94,000 on accrual basis), and a tax rate of 34%. What is the deferred tax asset/liability in this case? A deferred tax: A) asset of $48,960. B) asset of $8,500. C) liability of $8,500. The ans from qbank: Since taxable income ($119,000) exceeds pretax income ($94,000), Camphor will have a deferred tax asset of $8,500 = [($119,000 ? $94,000)(0.34)]. How do i define which is pretax and which is taxable income? The way I approach this question is since the company has collect $119,000 cash and accrued revenue of $94,000 which they have not receive, the company will have to pay the tax for the $119,000 collected. Thats why i consider cash collections from customers as Pretax (which multiply by the tax rate to arrive at tax expense) and the accrued amount as the taxable. Therefore my ans is C which is wrong according to qbank. Is my way of understanding this question wrong? Pls advise. Thanks
One thing I notice right away is that because the cash collections are larger and accruals, there will be a larger tax payment than will be listed on the financial reports. here is how i work this: FR purposes Revenue- 188,000 expenses- 94,000 gross income- 94,000 taxes- 94,000 x .34 = 31,960 Tax Purposes Revenue- 238,000 expenses- 119,000 gross income- 119,000 taxes- 119,000 x .34 = 40,460 So this company actually paid out 40,460 but has only reported 31,960 (this creates a deferred tax asset so answer C is eliminated right away. 40,460 - 31,960 = a deferred tax asset of 8,500 answer B Just remember that if the reported taxes are less than actual, a deferred tax asset is created. If reported taxes are more than actual, a deferred tax liability is created.
Hi CFACOUNTRY, thanks for the explanation. Here come the confusing part which i’m still trying to comprehend. Based on what you have mention that the company actually paid out $40,460 but has only reported $31,960, can i consider the value $40,460 as tax expense? It is because since $40,460 has to be paid out, it will be consider as an expense. (correct me if i’m wrong) I’m confused because according to the kaplan notes on LOS 38.b under study session 9, it defines deferred tax liability as: A deferred tax liability is created when income tax expense (income statement) is greater than tax payable due to temporary difference. Thanks 
I think you may be getting confused by the definition. Yes, the $40,460 is considered an expense, but only $31,960 of that is recognized in the current year. This means that the remaining $8,500 in tax will be recognized in the future, but it has already been paid. So when that $8,500 is recognized later on, there will actually be no cash outflow from the firm (they are just acknowleding the expense). Lets clarify the Kaplan definition: A deferred tax liability is created when income tax expense (income statement; which is the $31,960) is greater than tax payable (which is the $40,460) due to temporary difference. The numbers to not match the definition of a deferred tax liability. Lets think of the definition for a Deferred Tax Asset then (just switch it around): A deferred tax asset is created when tax payable (which is the $40,460) is greater than income tax expense (income statement; which is the $31,960) due to temporary difference. This does satisfy the definition of a deferred tax asset. Does this clear things up?
oh i see. Thanks for the explanation CFAcountry. Your last post prompt me to find more about the taxable income terminology because i think my understanding on this concept must be wrong. After goggling, i finally got an answer. http://www.1st-stock-investment.com/economic-value-added/income-taxes-deferred-taxes/taxable-income-temporary-differences-pretax-financial-income.php Initially i thought that tax expense is the amount i need to pay to the government. Actually it is the Tax payable which i need to pay to the government. Whoa… Thanks CFAcountry. Your explanation really help me a lot:)